FOREX-Euro set for 2nd biggest weekly drop in 4 months as hedges in focus

LONDON, Feb 23 (Reuters) - The euro slipped on Friday and is set to post its second biggest weekly loss in nearly four months as investors focused on adding hedges to their portfolios before a big week for foreign exchange markets from a European politics perspective.

The outcome of the Italian general election is due on March 4 and the German Social Democrats poll of its members on joining another coalition government with Chancellor Merkel´s conservatives is also due that day, two big political risk events for markets which may trigger fresh market volatility.

Hedging-related strategies were popular as investors rushed to the currency derivative markets in short tenors to buy option contracts to cover the period over those two events.

In a market where long euro bets are at their largest on record, according to CFTC positioning data, any less than optimal results from either of these two major political events may prompt some hedge funds to sell the single currency.

One trader at a European bank said demand for currency options for euro/dollar around the 1.21 and 1.25 levels over one-week and two-week tenors were seeing "decent demand".

Thomson Reuters data showed a buildup in large option bets around those levels.

Implied volatility on the euro for two-week maturities , a gauge of expected currency swings, was at its highest levels since the outcome of the French elections last April, indicating that some investors were taking no chances.

Risk reversals for two-week maturities, a measure of the extent of positioning in currency derivatives, showed a distinct pick up in the preference for buying euro/dollar puts rather than calls, suggesting investors were protecting against downside risks.

However, market analysts cautioned against reading too much into the derivative markets as the overall perception of political risk in Europe has reduced considerably.

"Political risk is not as much of a factor for the euro as it was last year as risk perception has moderated considerably and for good reason, with Eurosceptic parties moderating their stance to appeal to a wider base," said Lefteris Farmakis, a macro strategist at UBS in London.

CONSTRUCTIVE OUTLOOK

However, with recent surveys and the European Central Bank's minutes of its January policy showing some signs of caution among policymakers about the bloc's economic prospects with the backdrop of a strong euro, investors are searching for fresh catalysts to drive the currency higher.

"Apart from some political concerns, the dollar's outlook also appears to be more constructive in the short term thanks to the rising yields," said Manuel Oliveri, an FX strategist at Credit Agricole in London.

Markets are assuming from opinion polls that there will be no clear winner to the Italian polls, with either some loose coalition or a minority government likely to emerge.

Indicating the growing caution among European policymakers, ECB officials rejected even a token change in the bank's policy message, arguing that it was premature to signal policy normalisation given weak inflation, the minutes of its January meeting showed on Thursday.

That caution is also reverberating in the bond markets. While German government debt yields have risen by 38 basis points since early December, the rise has been slower than in the United States, where yields are up more than 50 bps.

Benchmark Treasury 10-year note yields rose to a four-year high of 2.957 percent on Wednesday before falling back to 2.904 percent on Thursday.

The prospect of the U.S. government boosting debt issuance to fund expanded stimulus and the Federal Reserve hiking interest rates steadily this year are some of the factors that have contributed to the rise in yields.

The dollar index against a basket of six major currencies rose 0.2 percent to 89.873.

The index reached a 10-day high of 90.235 on Thursday, from a three-year trough of 88.253 late last week, before its rally lost a bit of steam. It was on still on track to gain 0.9 percent on the week.

The yen showed little reaction to data which showed Japan's annual core consumer inflation rate was unchanged in January from the previous month, reinforcing views that the Bank of Japan remains far from exiting its super loose monetary policy.